The exchange rate
expresses the national currency's quotation in respect to foreign
ones. For example, if one US dollar is worth 10 000 Japanese Yen, then
the exchange rate of dollar is 10 000 Yen. If something costs 30 000 Yen,
it automatically costs 3 US dollars as a matter of accountancy. Going
on with fictious numbers, a Japan GDP of 8 million
Yen would then be worth 800 Dollars.

Thus, the exchange
rate is a conversion factor, a multiplier or a ratio, depending
on the direction of conversion.

In a slightly different perspective,
the exchange rate is a price. If the exchange rate can freely move,
the exchange rate may turn out to be the fastest moving price
in the economy, bringing together all the foreign goods with it.

Types
of exchange rate

It is customary
to distinguish nominal exchange rates from real exchange
rates. Nominal exchange rates are established on currency financial
markets called "forex markets", which are similar to stock exchange
markets. Rates are usually established in continuous quotation, with newspaper
reporting daily quotation (as average or finishing quotation in the trade
day on a specific market). Central bank may also fix the nominal exchange
rate.

Real exchange rates are nominal
rate corrected somehow by inflation
measures. For instance, if a country A has an inflation rate of 10%, country
B an inflation of 5%, and no changes in the nominal exchange rate took
place, then country A has now a currency whose real value is 10%-5%=5%
higher than before [1]. In fact, higher
prices mean an appreciation of the real exchange rate, other things equal.

Another classification of exchange
rates is based on the number of currencies taken into account. Bilateral
exchange rates clearly relate to two countries' currencies. They are usually
the results of matching of demand and supply on financial markets
or in banking transaction. In this latter case, the central bank
acts usually as one of the sides of the relationship.

Other bilateral exchange rates may
be simply computed from triangular relationships: if the
exchange rate dollar/yen is 10 000 and the dollar/Angolan kwanza is 100
000 then, as a matter of computation, one yen is worth 10 kwanza. No direct
yen/kwanza transaction needs to take place. If, instead,a financial market
exists for yen to be exchanged with kwanza, the expectation is that actions
by speculators (arbitrage among markets) will bring the parity
of 10 kwanza per yen as an effect.

Multilateral exchange rates
are computed in order to judge the general dynamics of a country's currency
toward the rest of the world. One takes a basket of different currencies,
select a (more or less) meaningful set of relative weights, then
computes the "effective" exchange rate of that country's currency.

For instance, having a basket made
up of 40% US dollars and 60% German marks, a currency that suffered from
a value loss of 10% in respect to dollar and 40% to mark will be said
having faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%.

Some countries impose the existence
of more than one exchange rate, depending on the type and the subjects
of the transaction. Multiple exchange rates then exist, usually
referring to commercial vs. public transactions or consumption and investment
imports. This situation requires always some degree of capital controls.

In many countries, beside the official
exchange rate, the black market offers foreign currency at another,
usually much higher, rate.

Exchange
rate regimes

When
the exchange rate can freely move, assuming any value that private
demand and supply jointly establish, "freely floating exchange
rate" will be the name of currency institutional regime. Equivalently,
it is called "flexible" exchange rate as well.

If
the central bank timely and significantly intervenes on the currency
market, a "managed floating exchange rate regime" takes place.
The central bank intervention can have an explicit target, for example
in term of a band of currency acceptable values.

In
"freely" and "managed" floating regimes, a loss in currency value is conventionally
called a "depreciation", whereas an increase of currency's international
value will be called "appreciation". If the dollar rise from 10 000 yen
to 12 000 yen, then it has shown an appreciation of 20%. Symmetrically,
the yen has undergone an 8.3% depreciation.

But
central banks can also declare a fixed exchange rate, offering
to supply or buy any quantity of domestic or foreign currencies
at that rate. In this case, one talks of a "fixed exchange rate".

Under
this regime, a loss of value, usually forced by market or a purposeful
policy action, is called a "devaluation", whereas an increase of international
value is a "revaluation".

The
most stabile fixed exchange regimes are backed by an international
agreement on respective currency values, often with a formal obligation
of loans among central banks in case of necessity.

A
"currency crisis" is a rupture of fixed exchange rates with an
unwilling devaluation or even the end of that regime in favour of a floating
exchange rate. It can dominate the attention of the public, policymakers
and entrepreneurs, both in advance and after. For instance, people expecting
a crisis can borrow inside the country, convert in a foreign currency,
lend that money (e.g. by purchasing bonds). When the crisis comes, they
sell the bonds, convert to the national currency, pay back their loans,
and gain a hefty profit.

An
extreme national engagement to fixed exchange rates is the transformation
of the central bank in a mere "currency board" with no autonomous
influence on monetary stock. The bank will automatically print or lend
money depending on corresponding foreign currency
reserves. Thus, exports, imports
and capital inflows (e.g. FDI) will largely determine
the monetary policy.

Monetary
unions phase out the national currencies in favour of one (new or
existing). Some further countries can target to join the union and put
in place economic and financial policies to that aim, especially if there
are explicit conditions for entering into that monetary area. Exiting
a monetary union can provoke with large devaluation of the new national
currency. Depending on trade elasticities,
on foreign debt of the country, on how the exit is managed and on the
overall institutional conditions, this can lead to massive internal poverty
or a large export led-growth.

Determinantsof the nominal exchange

Fixed exchange
rates are chosen by central banks and they may turn out to be more
or less accepted by financial markets.

Changes in floating rates or
pressures on fixed rates will derive, as for other financial assets,
from three broad categories of determinants:

i) variables on
the "real" side of the economy;
ii) monetary and financial variables determined in cross-linked
markets;
iii) past and expected values of the same financial market with
its autonomous dynamics.

A rising trade surplus will increase
the demand for country's currency by foreigners, so that there should
be a pressure for appreciation. A trade deficit should weaken the currency.

Were exports and imports largely
determined by price competitiveness and were the exchange rate very reacting
to trade unbalances, then any deficit would imply depreciation, followed
by booming exports and falling imports. Thus, the initial deficit would
be quickly reversed. Net trade balance
would almost always be zero.

This is hardly the case in
contemporary world economy. Trade unbalances are quite persistent,
as you can verify with these real
world data. Additionally, not so seldom, exchange rates go in the
opposite direction than one would infer from trade
balance only.

2. An even
more radical form of real determination of exchange rate is offered by
the "one price law", according to which any good has the same price
worldwide, after taken into account nominal exchange rates. If a hamburger
costs 3 US dollars in the United States and 30 000 yen in Japan, then
the exchange rate must be 10 000 yen per dollar. The forex market
would passively adjust to permit the functioning of the "one price
law".

But in order to equalise the price
of several goods, more than one exchange rate may turn out to be "necessary".
Moreover the "one price law" seems to suffer from too many exceptions
to be accepted as the fundamental determinant of exchange rates.

Large, persistent and systematic
violations of Purchasing Power Parity are connected to price-to-market
decisions of firms in this paper
of September 2007.

Monetary
and financial variables in cross-linked markets

1. Interest
rates on Treasury bonds should influence the decision of
foreigners to purchase currency in order to buy them. In this case, higher
interest rates attract capital from abroad and the currency should appreciate.
Decisive would be the difference between domestic and foreign interest
rates, thus a reduction in interest rates abroad would have the same effects.

Similarly
other fixed-interest financial instruments could be objects of the same
dynamics. Accordingly, an increase of domestic interest rates by the central
bank is usually considered a way to "defend" the currency.

Nonetheless, it may happen that
foreigners rather buy shares instead of Treasury bonds. If this
were the strongest component of currency demand, then an increase of interest
rate may even provoke the opposite results, since an increase of
interest rate quite often depresses the stock market, favouring a tide
of share sales by foreigners.

In the same "reversed" direction
foreign directinvestments
would work: arestrictive monetary policy usually depresses the growth
perspective of the economy. If FDI are mainly attracted
by sales perspectives and they constitute a large component of capital
flows, then FDI inflow might stop and the currency weaken.

Needless to say, those conditions
are quite restrictive and not so usually met.

As a temporary conclusion, interest
rates should have an important impact on exchange rate but one has
to be careful to check additional conditions.

2. Inflation
rate is often considered as a determinant of the exchange rate
as well. A high inflation should be accompanied by depreciation. The more
so if other countries enjoy lower inflation rates, since it should be
the difference between domestic and foreign inflation rates to determine
the direction and the scale of exchange rate movements.

All this would be implied by a weak
version of "one price law" stating that price dynamics of a good are the
same worldwide, after taking into account nominal exchange rates. Thus,
here not absolute level but just the percentage differences in
price are requested to be equalised .

If an hamburger costs in Japan 5%
more than a year ago, while in USA it costs 8% more, then the dollar should
have been depreciated this year by about 8-5=3%.

But in order to equalise the price
dynamics of different goods, more than one exchange rate change may turn
out to be "necessary".

In reference to the overall price
level of the economy, if exchange rates would move exactly counterbalancing
inflation dynamics, then real exchange rates should be constant.
On the contrary, this is not true as a strict universal rule.

Still, even if this weak version
of the "law" does not always hold, high inflation usually give
rise to depreciation, whose exact dimension need not match
the inflation itself or its difference with foreign inflation rates.

3. Thebalance of payments can highlight pressures for devaluation
or revaluation, reflected in large and systematic trend of foreign currency
reserves at the central bank. In particular, large inflows, due for instance
to a rise in the world price of main export items, tend to raise the exchange
rate. Conversely, a collapse in the trust of government to manage the
economic conditions might provoke a flight of capital, the exhaustion
of foreign currency reserves and force devaluation / depreciation.

Autonomous
dynamics on the forex market

Past and expected
values of the exchange rate itself may impact on current values
of it. The activities of forex specialists and investors may turn out
to be extremely relevant to the determination of market exchange rate
also thanks to their complex interaction with central banks. Sophisticated
financial instruments like futures on exchange rates may play an
important role. Imitation and positive
feedbacks give rise to herd behaviour and financial fashions.

Fears and confidence
in a currency are heterogeneosly distributed across agents, with special
events (as unexpected news) realigning them and generating large movement
in the exchange rate.

For a full-text
free book on artificial forex market based on empirical field research
see here.

Impact
on other variables

Levels
and fluctuations in the exchange rate exert a powerful impact on exports,
imports and the trade
balance. A high and rising exchange rate tends to depress
exports, to boost import and to deteriorate the trade balance,
as far as these variables respond to price stimuli. Consumers
find foreign goods cheaper so the consumption composition
will change. Similarly, firms will reduce their costs
by purchasing intermediate goods abroad.

A
devaluation or depreciation should work in the opposite direction,
improving the trade balance thanks to soaring
exports and falling imports.

If,
however, imports have an elasticity to price
less than 1, their values in local currency will grow instead of falling.
Moreover, if the state, the citizens and / or the enterprises have a debt
denominated in a foreign currency, their principal and the interests to
be paid soar because of the devaluation. They usually squeeze other expenditures
and launch a recessionary impulse throughout the economy.

Previous
investors in real estate and other assets would be hurt by devaluation,
so the perspective of such a dynamics makes investors cautious and might
sink FDI.

External
debt denominated in foreign currency can, if large enough, provide considerable
effects on the positive or negative impact of fluctuation. A devaluation
with a large external debt provokes a larger outflows of interest payments
(expressed in local currency), possibly squeezing the economy and the
public budget, with recessionary effects.

For industries where production can be flexibly exported,
devaluation offers important opportunities for growth and profitability.
Conversely, industries selling exclusively on the domestic market (e.g.
the building industry) may see their costs rising while purchasing power
of their clients declines or remains at the same level, which erodes their
profits and can even lead to bankruptcies. In other words, devaluation
polarises the economy across industries.

Hosting
different industries, regions usually exhibit a differentiated
degree of international openness: exchange rate fluctuations will have
an uneven impact on them.

Similarly,
the number of job places and the working conditions
may be influenced by the degree of international competition and exchange
rates levels.

Exchange
rate influences also the external purchasing power of residents
abroad, for example in term of purchasing real estate and other assets
(e.g. firm equity as a foreign direct investment),
so by different channels, also the balance of payments.

Exchange
rate devaluation (or depreciation) gives rise to inflationary
pressures: imported good become more expensive both to the direct
consumer and to domestic producer using them for further processing. In
reaction to inflation (actual and feared), the central bank can rise the
interest rates, thus sending a recessionary impulse. Similiarly, a package
of fiscal austerity (expenditure cuts and selective tax increase), freezing
wages and privatising loss-generating public assets is sometimes imposed
after the currency crisis.

Currency
crisis have a sweeping impact on income distribution. The few rich able
to borrow (because they have collateral and the banks trust them) will
get richer and the people purchasing imported goods facing inflation and
reduction of real incomes.

Symmetrically,
the central bank may use a fixed exchange rate as a nominal anchor
for the economy to keep inflation under control, compelling domestic producer
to face tougher competition if they were to decide to increase prices
or accept to pay higher wages.

Were
adjustment perfect, as rational expectations models would normally posits,
inflation would immediately go to zero and there would be no effect on
the real economy. Instead, real-world experiences show that even when
successful in taming inflation (which is not always the case) the nominal
anchor leadd to appreciation in real tirms (as the remaining inflation
is not compensated by devaluation), which over the years can provoke structural
trade deficit and loss of competitiveness (together with foreing debt
with countries having a lower nominal interest rate). This conditions
is usually unsustainable in the long run.

For
a small economy, joining a monetary union makes the exchange rate to fluctuate
according to fundamentals and market pressures referring to a much larger
area, erratically going in directions that are (or are not) coherent with
positive macroeconomic developments.

For
statistics purposes, international comparisons of current values converted
to a common currency are "distorted" by wide exchange rate fluctuations.

Long-term
trends

Some geographical
monetary areas have enjoyed long periods of stable exchange rate,
with moments of consensual realignment after divergence in inflation rates.
Many countries strive to keep their currency at a fixed level toward the
dollar, the Euro (earlier the German mark) or a basket with multiple currencies.

Still, most currency progressively
devaluate, especially those issued by periphery
countries. The US dollar has extremely wide fluctuations with years
of "weak" and "strong" dollar.

Business
cycle behaviour

Too many elements
are at work for the exchange rate to exhibit a clearly-defined business
cycle behaviour. To the extent that the exchange rate is determined by
the trade balance, the exchange rate is
counter-cyclical as the latter. At peaks, the trade deficit
would depress the exchange rate, forcing it to depreciate.

If it is rather the interest
rate that turns out to the main driver of the exchange rate, a possible
pro-cyclicity of the interest rate would imply a pro-cyclical exchange
rate.

In this scenario, recovery
and boom are accompanied by rising interest rates
and exchange rates. At peaks, we would see very strong currency.
Together with domestic demand pressures, this would be the source of a
high trade deficit.

If autonomous dynamics in the forex
market are the main determinants of the exchange rate, then intense
micro-fluctuations and long term tides would ride the exchange rate,
possibly with central bank significant interventions.